The latest thinking from Greenspring Advisors.

Brain-Damaged Investors

J. Patrick Collins Jr., CFP®, EA

We've often talked about behavior being the key element in a successful investment experience.  We are starting to see signs of this behavior manifest itself in questions from clients asking if they should lighten up their exposure to emerging market stocks or energy investments.  Of course, these are areas of the market that have been hit the worst over the past several years.  It has been shown through countless studies that humans hate losses more than they love gains.  It has been hardwired into our DNA for thousands of years.  Fear kept us alive when we were living in the wild, dealing with life threatening risks on a daily basis.  Our fight or flight reaction has been finely tuned to allow our species to survive and thrive throughout human existence.  Unfortunately, those emotional responses that have been so beneficial over time are destroying our investment returns.  

When our investments fall, we get scared and our instincts tell us that something is wrong.  This is the way our brain has worked throughout time.  But what if we didn't get scared?  It was always more theory that our emotional response was hurting our returns, but 10 years ago an interesting study was done.  Here is the gist (from the WSJ):

The 41 participants in the new study included people with and without brain damage, including a control group of participants with brain damage that didn't affect their emotional processing. Players were given $20 and asked to play a simple gambling game that involved 20 rounds of coin tosses. If they won a coin toss, they earned $2.50. If they lost the toss, they had to give up a dollar. They could choose not to play in any given round, in which case they kept their dollar.

Logic indicates that the best strategy was to take the gamble in every round of the game, since the return on a win was much higher than the potential loss, and the risk in each round was 50-50. The players with emotion-related brain damage took a more logical strategy, investing in 84% of rounds, while the nonbrain-damaged players invested in just 58% of the rounds. Emotionally impaired participants outperformed the nonbrain-damaged participants, winding up with an average of $25.70 versus $22.80 at the end of the game.

How many investors take an approach like the non brain-damaged investor?  After they've lost money, they are less apt to play anymore.  I still come across investors who sold out of their investments in 2008 and never got back in.  Fear of loss is powerful.  It can make us behave irrationally.  How do we overcome this instinctive tendency?  First, before making any investment decisions, it is important to understand how you are feeling at that moment.  Am I scared?  Is this a logical decision?  Second, automate it.  Using a simple asset allocation strategy like a target date fund inside a 401k plan or an advisor managed model portfolio, allows us to make less decisions.  This is almost always a good thing.  Finally, and most importantly, get outside counsel.  Whether you work with a trusted advisor or just have someone you trust to go to when you are planning on making a change, it is important to find someone who will tell you what they are thinking.  Someone who doesn't have an emotional tie to your money but still is acting in your best interest.  Those investors who can not only recognize their emotional biases but also act against them (buying after a major drop in the market) will find tremendous success in the future.